Fed Easy Credit Becomes Inside Debate Focusing on Escape

A boy walks past the U.S. Department of the Treasury building in Washington. In December, the Federal Open Market Committee added $45 billion of monthly Treasury purchases. Photographer: Andrew Harrer/Bloomberg

The Fed is acquiring $85 billion of securities each month,
and policy makers are grappling with how to condition markets
not to interpret a stop in those purchases as a prelude to the
exit from easy credit. Bernanke said Dec. 12 in Washington that
he “would emphasize” the end won’t be “a turn to tighter
policy.”

If the Fed fails, interest rates may climb prematurely, as
traders arrange positions for the withdrawal of unprecedented
monetary stimulus, according to Dean Maki, chief U.S. economist
at Barclays Plc in New York. The Fed has kept its benchmark
federal funds rate near zero for more than four years and
swelled its balance sheet to a record of more than $3 trillion
through three asset-purchase programs.

“There is a risk the markets get ahead of the Fed,” said
Maki, a former Fed board economist. “It will be tricky for the
Fed to signal it’s going to stop buying without signaling that
tightening is imminent.”

Ending the Fed’s third round of so-called quantitative
easing carries greater significance than completion of the
previous two because those were introduced with defined amounts
and durations.

Open-Ended Program

For QE3, the Federal Open Market Committee in September
announced purchases of $40 billion a month in mortgage-backed
securities, leaving the program open-ended until the labor
market improves “substantially.” In December, the FOMC added
$45 billion of monthly Treasury purchases.

Marilyn Cohen, founder of Envision Capital Management Inc.
in Los Angeles, said she doesn’t think the Fed will be able to
convince traders that interest rates aren’t going up when the
central bank stops buying bonds. Cohen said she’s already
lowered the interest-rate sensitivity of her $325 million
portfolio in preparation.

“The markets are on edge; and any hint that things are
changing, and we will see the repercussions,” Cohen said.
“I’ve been in this business since 1979 -- I’m one of the old
dinosaurs -- and I cannot remember when there was such a chorus
in the investment landscape that all are calling for higher
rates.”

The Jan. 3 release of the minutes from the FOMC’s Dec.
11-12 meeting illustrates investors’ sensitivity, Cohen said.
Central bankers discussed possibly curtailing or halting their
asset purchases this year. That surprised analysts and traders,
sending the Standard & Poor’s 500 Index down 0.2 percent and
pushing up yields on the benchmark 10-year Treasury note 0.07
percentage point that day.

James Bullard, president of the Federal Reserve Bank of St.
Louis, says the “communication challenge” the central bank
faces with the end of QE3 is comparable to all periods of
easing.

“The same thing happens with interest-rate policy; you’re
lowering the interest rate, and after a while you decide to quit
lowering the interest rate and just hold it steady,” Bullard
said in a Feb. 1 interview in Washington. “And at that point,
you have to convince markets this is really a lower rate than it
used to be.”

Treasury Yields

U.S. 10-year government notes declined, pushing the yield
up two basis points, or 0.02 percentage point, to 1.97 percent
at 10:32 a.m. London time. Yields on thirty-year bonds also
climbed two basis points to 3.18 percent.

Fed Governor Jeremy Stein warned last week that the market
for speculative-grade debt may be overheating even as his
institution’s policy of keeping benchmark borrowing costs low is
pushing investors into riskier debt.

“We are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” Stein said in
a Feb. 7 speech in St. Louis. If the observation is accurate, he
said, “it does not bode well for the expected
returns to junk bond and leveraged-loan investors.”

Just because the Fed halts its asset purchases also doesn’t
mean it couldn’t restart them. Bernanke announced his first
quantitative-easing program in November 2008; it ran until March
2010, and QE2 lasted from November 2010 to June 2011.

Bullard’s View

Bullard said he expects U.S. growth will gain enough
momentum to let the central bank reduce the pace of bond buying
as early as the middle of the year. The unemployment rate will
fall to the “low 7s” by December from 7.9 percent in January,
which would meet the FOMC’s test of the “substantial
improvement” needed to end purchases, he predicted.

“It is going to be very difficult for them” to end QE3
without triggering a rise in borrowing costs, which may argue
for sticking with the program until the economy has sustainable
momentum, said Carl Lantz, head of interest-rate strategy at
Credit Suisse Group AG in New York.

Japan is one guidepost for Fed officials as they consider
how long to keep stimulus in place. The Bank of Japan lifted the
benchmark lending rate off zero in August 2000, before an
economic recovery had consolidated. Monetary-policy experts,
including former Fed Governor Frederic Mishkin, have called that
move a “mistake.”

“All throughout the crisis, Japan has been on their
mind,” said Mark Gertler, a New York University economics
professor who has co-authored research with Bernanke.

Numerical Thresholds

Investors eventually will have to take the Fed at its word:
The federal funds rate isn’t going to rise until the
unemployment and inflation goals are hit, Gertler said. If the
economy drifts further away from the thresholds -- as it has in
the most recent reports -- then investors should begin to expect
a longer period of rates near zero, and that provides continued
accommodation.

While the end of QE3 is tied to subjective criteria about
the labor market, policy makers have set specific numerical
thresholds for raising rates. The FOMC said in December, and
repeated in January, that “an exceptionally low range” for its
benchmark would be appropriate as long as inflation isn’t
forecast to rise more than 2.5 percent and unemployment remains
above 6.5 percent. These criteria replaced previous calendar-based guidance that rates would stay near zero at least through
the middle of 2015.

“The market is always looking for the next big thing,”
said Lou Crandall, chief economist at Wrightson ICAP LLC in
Jersey City, New Jersey. “Once the Fed stops buying assets,
everybody knows what the next big thing is: the beginning of the
exit cycle.”

Advance Signal

Even though Bernanke said Dec. 12 that the transition to
economic thresholds “doesn’t change our mid-2015 expectation,”
money-market-derivatives traders since have accelerated their
time frame for policy tightening.

Forward markets for overnight index swaps, whose rates show
what traders expect the federal-funds effective rate will
average over the life of the contract, signal a quarter
percentage-point advance around February or March of 2015,
according to data compiled by Bloomberg as of Feb. 5. In
December, these traders were pricing in a rate increase about
June 2015.

“There is no doubt that when the Fed pulls back you will
see a big shoot upward in Treasury yields,” said Karl Haeling,
head of strategic-debt distribution in New York at Landesbank
Baden-Wuerttemberg, one of Germany’s largest banks. “There are
a lot of people who think the only reason rates are here is
because the Fed put them here. Nobody wants to be the last man
standing.”